Taxes & Income Averaging

The Internal Revenue Service, or IRS, provides for preferential tax treatment on certain lump-sum distributions from qualified retirement plans. The tax treatments are called five-year and 10-year forward averaging. Instead of taxing a lump-sum distribution all at once, the IRS allows recipients of the distribution to recognize the income over a 10-year period. For example, a lump-sum distribution of $100,000 might send the taxpayer into a higher tax rate during the year of the distribution, whereas if you included the distribution as income at $10,000 per year, the annual taxes for each year might be less. The IRS requires that you meet certain conditions to use this treatment.

Conditions Required to Use Income Averaging

To use income averaging, you must participate in the plan for at least five years, and the entire balance in your sponsored plan must distribute in one year. Your date of birth must be before January 2, 1936 to qualify. You can only use this treatment once, so if you used the income averaging method in a prior year, you cannot use it again.

How to File

You must use form 4972 to claim either the five-year, or 10-year averaging method. The law applies to both you or your beneficiary. If your beneficiary receives the distribution, you must be at least 59 1/2 years old before your death.

Paying the Taxes

The five-year or 10-year averaging methods don’t defer taxes. You must pay the full tax due in the year you receive the distribution, although the averaging methods will potentially reduce your tax rate that you use in the tax calculation.

Considerations

You should consult with a tax professional such as an enrolled agent or Certified Public Accountant when you file taxes in a year that includes a lump-sum distribution. You also have the option to treat the distribution in another way. You might be able to defer the taxes to a future year by rolling over the distribution to another qualified retirement plan. This way, you'll pay the taxes in a future year when you decide to receive either a lump-sum or monthly payments.

References

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I graduated with a degree in Finance from Cal Poly Pomona and have held an active Brokers License for over 30 years. I also owned an accounting and tax practice for ten years. I'm an expert in all matter relating to mortgages, accounting, small businesses and taxation, and investing.